ECONOMICS
A-LEVEL edexcel (Multiple choice & Essays)
Basic economic problem - scarcity & choice
The purpose of economic activity
It is often said that the central purpose of economic activity
is the production of goods and services to satisfy our
ever-changing needs and wants.
The basic economic problem is about scarcity and choice. Every
society has to decide:
What goods and services to produce?Does the economy uses its
resources to build more hospitals, roads, schools or luxury hotels?
Do we make more iPhones and iPads or double-espressos? Does the
National Health Service provide free IVF treatment for childless
couples?
How best to produce goods and services?What is the best use of
our scarce resources? Should school playing fields be sold off to
provide more land for affordable housing? Should we subsidise the
purchase of solar panels for roofs?
Who is to receive goods and services?Who will get expensive
hospital treatment - and who not? Should there be a minimum wage?
Or perhaps a living wage? What are the causes and consequences of
poverty in societies across the globe?
Scarcity
We are always uncovering of new wants and needs which producers
attempt to supply by using factors of production. For a perspective
on the achievements of countries in meeting peoples basic needs,
theHuman Development Indexproduced by the United Nations is worth
reading. The economistAmartya Sen(Winner of the 1998 Nobel Prize
for Economics) has written extensively on this issue.
Scarcity means we all have to make choices
Because of scarcity,choicesmust be made by consumers, businesses
and governments. For example, over six million people travel into
London each day and they make decisions about when to travel,
whether to use the bus, the tube, to walk or cycle or work from
home. Millions of decisions are taken, many of them are habitual
but somehow on most days, people get to work on time and they get
home too in safety if not in comfort!
Making achoicemade normally involves atrade-off this means that
choosing more of one thing can only be achieved by giving up
something else in exchange.
Every purchase is a trade-off, of course. If you decide to spend
$20,000 on a new car, youre saying thats worth more to you than 20
bicycles or four vacations to Europe or the down payment on a
house. Every choice involves opportunity costs; when you choose one
thing, youre giving up others. Plus, what youre giving up isnt
always financial.Or obvious.1. Housing:Choices about whether to
rent or buy a home both decisions involverisk. People have to weigh
up thecostsandbenefitsof the decision.
2. Working:Do you work full-time or part-time? Is it worth your
while studying for a degree? How have these choices been affected
by the introduction of university tuition fees?
3. Transport and travel:The choice between using Euro-Tunnel, a
low-cost ferry or an airline when travelling to Western Europe.
In many decisions where people consider thecostsandbenefitsof
their actions economists make use of themarginal idea, for example
what are the benefits of consuminga little extraof a product and
what are the costs?
Rational decision-makersweigh the marginal benefit one receives
from an option with its marginal cost, including the opportunity
cost.
Thiscost benefit principlewell applied will get you a long way
in economics!
But keep in mind that behavioural economics questions the
rationality of many of our decisions!
Housing
The determination of price levels in local housing markets are
great examples of microeconomics in action! Each day there are
hundreds and thousands of separate negotiations between buyers and
sellers with prices being offered and agreed before a final
transaction is made.
The price that is established with each housing transaction in
the market depends on
The price that the seller is willing to agree for their
property.
The actual price that the buyer is willing and able to pay
A Sellers Market
When demand for properties in a locality, area or region is high
and when there is a shortage of properties then the balance of
power in the market shifts towards the seller. They can wait for
offers on their property to reach (or exceed) their minimum selling
price. Indeed early potential buyers may come straight in with an
offer in excess of the asking price in order to avoid the
possibility of losing the property that they want.
A Buyers Market
When there is a glut of properties available on the market
(excess supply), the balance of power switches to buyers. They have
the luxury of a wider choice of housing and they should be able to
negotiate a price lower than the published price. Sellers may
require a quick sale and this puts extra bargaining power into the
hands of buyers.
Housing Demand
The demand for housing is the quantity of properties that
homebuyers are willing and able to buy at a given price in a given
time period. Some of the conditions of demand in the market are as
follows:
Real Incomes: As living standards rise, so the demand for
housing expands, including demand for more expensive properties as
people move up market.
Mortgage Interest Rates: Since most homes are purchased with a
mortgage, changes in interest rates affect demand for housing. A
rise in mortgage rates increases the cost of financing the loan on
the purchase of a property.
Consumer confidence: Consumer confidence is vital for if
expectations for the future performance of the economy deteriorate
and people become less optimistic about their own financial
circumstances, they may be tempted to delay entry into the market
for property.
Economic Growth: When the economy is enjoying sustained growth
and rising prosperity, improved confidence raises the number of
homebuyers. The reverse is true in a recession.
Unemployment: In areas or regions when unemployment is above the
national average, incomes will be lower and this limits the number
of people who are able to afford properties.
The Price of Substitutes: For people wanting to buy their own
home, the main alternative is to rent so a higher cost of renting
could lead to an increased demand for owner-occupied homes.
Effective demand for housing property affordability
Demand in a market is only effective when potential buyers have
the ability to pay. Nowhere is this truer than in the property
market. In recent years the boom in house prices in the UK caused a
major affordability problem for millions of people wanting to enter
the market for the first time. The ratio of average prices to
incomes climbed higher and made it much more expensive to take out
a mortgage. The decline in effective demand has been an important
factor bringing about an end to the boom as first-time-buyers have
gradually disappeared from the market.
Since the summer of 2007 house prices have been falling and as a
result, the ratio of prices to earnings has dropped indicating an
improvement in this measure of housing affordability. However
although properties look more affordable at first glance, the
difficulties in getting a mortgage following the credit crunch
means that demand in the property market has remained subdued.
Price elasticity of demand for housing
Price elasticity of demand (Ped) measures the responsiveness of
demand for a product to a change in its own price. When housing is
regarded as a necessity and when there are few close substitutes
available, we expect demand to be inelastic. This may well force up
the eventual market price when a transaction is agreed.
The price elasticity of demand for a property depends on the
availability of close substitutes for example the supply of rented
housing. If you have set your heart on a particular property, or
are convinced that you need to live in a specific area, perhaps to
live within a school catchment area or because you want to be close
to friends and family, then you will be far less sensitive to the
market price and demand will become price inelastic.
Housing Supply
The housing supply is the total flow of properties available at
a given price in a given time period. The supply will be a mix of
newly-built housing and older properties. For new housing, the
conditions of supply include the following:
1. Costs of productionfor construction companies
a. Employment costs (including wages, overtime payments and
employment taxes).
b. Costs of purchasing land for housing development.
c. Costs of purchasing building components and raw
materials.
d. Costs associated with achieving planning consent from local
authorities.
1. Thenumber of construction companiesin the market and their
business objectives.
2. The extent to which property builders can achieveeconomies of
scalein house building and reduce their constructions costs by
implementing innovation in building projects.
3. Government taxation and subsidyof new housing
developments
Elasticity of Housing Supply
The supply of new housing tends to be inelastic in the short run
which means that house prices are determined almost exclusively by
demand factors such as income, unemployment and interest rates.
Several reasons have been put forward for the low price elasticity
of supply of housing:
1. Construction companies cannot suddenly plan and then build
thousands of new homes in areas when there is an increase in
demand. One reason is the existence of planning regulations and
other constraints on new housing developments.
2. Supply is also restricted by the limited availability of
skilled labour such as bricklayers and electricians and other
factor inputs needed in the construction process.
Explaining property price differences
What supply and demand factors might help to explain persistent
differentials in property prices in different parts of the UK?
Consider the evidence shown in the chart above average prices in
London have outstripped those for the UK as a whole for many years
not and the gap has widened:
Some the factors might include:
Population growth driving total market demand for housing higher
every year
The absence of a ready supply of affordable rented housing and
social housing
Higher per capita incomes among people living in London even
though the unemployment rate is higher than the national average
(there are many economically-deprived boroughs in the capital
city)
High land prices which increases the cost of acquiring land for
new property development
Higher wage costs when employing skilled workers in the
construction industry
The impact of high speculative demand for new properties in
London especially from overseas buyers
DEMAND
What is meant by demand? Demandis the quantity of a good or
service that consumers arewilling and able to buyat agiven price in
a given time period.
Each of us has anindividual demandfor particular goods and
services and our demand at each price reflects thevaluethat we
place on a product, linked usually to the enjoyment or usefulness
that we expect from consuming it. Economists give this a term
-utilityEffective demandDemand is different to desire! Effective
demand is when a desire to buy a product is backed up byan ability
to payfor it
Latent DemandLatent demandexists when there is willingness to
buy among people for a good or service, but where consumers lack
the purchasing power to be able to afford the product.
Derived DemandThe demand for a product X might be connected to
the demand for a related product Y giving rise to the idea of
aderived demand. For example, demand for steel is strongly linked
to the demand for new vehicles and other manufactured products, so
that when an economy goes into a recession, so we expect the demand
for steel to decline likewise.
Steel is acyclical industrywhich means that market demand for
steel is affected by changes in the economic cycle and also by
fluctuations in the exchange rate.
The demand for new bricks is derived from the demand for the
final output of the construction industry- when there is a recovery
in the British building industry, so the market demand for bricks
will increase
Zincis a good example of a product with astrong derived demand.
It has a wide-range of end uses such as galvanised zinc used in
cars and new buildings, die-casting used in door furniture and
toys, brass and bronze used in taps and pipes. And also rolled zinc
(used in roofing, guttering and batteries) and in chemicals used in
making tyres and zinc cream.
The Law of DemandThere is aninverse relationship between the
price of a good and demand.
As prices fall, we see anexpansion of demand. If price rises,
there will be acontraction of demand.
Ceteris paribus assumptionMany factors affect demand. When
drawing a demand curve, economists assume all factors are held
constant except one the price of the product itself. Ceteris
paribus allows us toisolatethe effect of one variable on another
variable
The Demand CurveA demand curve shows the relationship between
the price of an item and the quantity demanded over a period of
time. There are two reasons why more is demanded as price
falls:
The Income Effect:There is an income effect when the price of a
good falls because the consumer can maintain the same consumption
for less expenditure. Provided that the good is normal, some of the
resulting increase in real income is used to buy more of this
product.
The Substitution Effect:There is a substitution effect when the
price of a good falls because the product is now relatively cheaper
than an alternative item and some consumers switch their spending
from the alternative good or service.
As price falls, a person switches away from rival products
towards the product
As price falls, a persons willingness and ability to buy the
product increases
As price falls, a persons opportunity cost of purchasing the
product falls
Note: Many demand curves are drawn as straight lines to make the
diagrams easier to interpret.
Production Possibility Frontier ("PPF")
Aproduction possibility frontier(PPF) is a curve or a boundary
which shows the combinations of two or more goods and services that
can be produced whilstusing all of the available factor resources
efficiently.
We normally draw a PPF on a diagram as concave to the origin.
This is because the extra output resulting from allocating more
resources to one particular good may fall. I.e. as we move down the
PPF, as more resources are allocated towards Good Y, the extra
output gets smaller and more of Good X has to be given up in order
to produce the extra output of Good Y. This is known as the
principle ofdiminishing returns. Diminishing returns occurs because
not all factor inputs are equally suited to producing different
goods and services.
Combinations of output of goods X and Y lying inside the PPF
occur when there areunemployed resourcesor when the economy uses
resourcesinefficiently. In the diagram above, point X is an example
of this. We could increase total output by moving towards the
production possibility frontier and reaching any of points C, A or
B.
Point D is unattainable at the moment because it lies beyond the
PPF. A country would require anincrease in factor resources, or
anincrease in the efficiency (or productivity)of factor resources
or animprovement in technologyto reach this combination of Good X
and Good Y. If we achieve this then output combination D may become
attainable.
Producing more of both goods would represent an improvement in
our economic welfare providing that the products are giving
consumers a positive satisfaction and therefore an improvement in
what is calledallocative efficiency
Reallocating scarce resourcesfrom one product to another
involves anopportunity cost. If we go back to the previous PPF
diagram, if we increase our output of Good X (i.e. a movement along
the PPF from point A to point B) then fewer resources are available
to produce good Y. Because of the shape of the PPF the opportunity
cost of switching resources increases i.e. we have to give up more
of Good Y to achieve gains in the output of good X.
The PPF does not always have to be drawn as a curve. If the
opportunity cost for producing two products is constant, then we
draw the PPF as a straight line. The gradient of that line is a way
of measuring the opportunity cost between two goods.
Explaining Shifts in the Production Possibility Frontier
The production possibility frontier will shift when:
There areimprovements in productivity and efficiencyperhaps
because of the introduction ofnew technologyoradvances in the
techniques of production)
More factor resources are exploitedperhaps due to an increase in
the size of the workforce or a rise in the amount of capital
equipment available for businesses
In the diagram below, there is an improvement in technology
which shifts the PPF outwards. As a result of this, output
possibilities have increased and we can conclude (providing the
good provides positive satisfaction to consumers) that there is an
improvement in economic welfare.
Technology, prices and consumer welfare
Improved technologyshould bring market prices down and make
products more affordable to the consumer. This has been the case in
the market for personal computers and digital products. The
exploitation ofeconomies of scaleand improvements in production
technology has brought prices down for consumers and
businesses.
External Costs
In the case of air pollution there is anexternal costto society
arising from the contamination of our air supplies.External
costsare those costs faced by a third party for which no
compensation is forthcoming. Identifying and then estimating a
monetary value for air pollution can be a very difficult exercise
but one that is important for economists concerned with the impact
of economic activity on our environment. We will consider this
issue in more detail when we studyexternalitiesandmarket
failure.
Free Goods
Not all goods have an opportunity cost.Free goods are not
scarceand no cost is involved when consuming them.
Is fresh air an example of a free good? Usually the answer is
yes yet we know that air can become contaminated by pollutants.
And, in thousands of offices, shops and schools, air-conditioning
systems cool the air before it is consumed. With air conditioning,
scarce resources are used up in providing the product for example
the capital machinery and technology that goes into manufacturing
the air conditioning equipment; the labour involved in its design,
production, distribution and maintenance and the energy used up in
powering the system.
Cool air might appear to be free but in fact it is often an
expensive product to supply!
Specialisation and trade
Specialisationis when we concentrate on a product or task.
Specialisation happens at all levels:
The specialization of tasks within extended families in many of
the worlds poorest countries
Within businesses and organizations
In a country Bangladesh is a major producer and exporter of
textiles; Norway is a leading oil exporter. And Ghana is one of the
biggest producers of cocoa in the world.
In a region of a country for many years the West Midlands has
been a centre for motor car assembly, there has been huge
investment in recent years in the Mini plant at Oxford
What are the possible gains from specialization?
By concentrating on what people and businesses do best rather
than relying on self sufficiency:
Higher output: Total production of goods and services is raised
and quality can be improved
Variety;Consumers have access to a greater variety of higher
quality products
A bigger market:Specialisation and global trade increase the
size of the market offering opportunities for economies of
scale
Competition and lower prices:Increased competition acts as an
incentive to minimise costs, keep prices down and therefore
maintains low inflation
The Division of Labour
Thedivision of labouroccurs where production is broken down into
many separate tasks. Division of labour raisesoutput per personas
people become proficient through constant repetition of a task
learning by doing. This gain in productivity helps to lower cost
per unit and ought to lead to lower prices for consumers.
1. Unrewarding, repetitive work that requires little skill
lowersmotivationand hitsproductivity. Workers begin to take less
pride in their work and quality suffers. We often see dissatisfied
workers becoming less punctual at work and the rate
ofabsenteeismincreases.
2. Many people may choose to move to less boring jobs creating a
problem ofhigh worker turnoverfor businesses. In 2010, the overall
employee turnover rate for the UK was 13.5% per year, nearly one
worker in seven changes jobs each year. The highest labour turnover
is found in retailing, hotels, catering and leisure, call centres
and among other lower paid private sector services groups
3. Some workers receive littletrainingand may not be able to
find alternative jobs if they find themselves out of work - they
may then sufferstructural unemployment.
4. Another disadvantage is that mass-produced standardized goods
tend to lack variety for consumers
Comparative advantage and the gains from specialisation and
tradeCountries will usually specialise in and export products,
which use intensively the factors inputs, which they are most
abundantlyendowed. For example the Canadian economy which is rich
in low cost land is able to exploit this by specializing in
agricultural production. The dynamic Asian economies including
China has focused their resources in exporting low-cost
manufactured goods which take advantage of muchlower labour
costs.This is now changing as China looks to move from a
middle-income country by specializing in industries that use higher
levels of knowledge and technology.
In highly developed countries, the comparative advantage is
shifting towards specializing in producing and then
exportinghigh-value and high-technology manufactured
goodsandhigh-knowledge services.
The PPF and the effects of specialisation
Two countries are producing two products (X and Y). With a given
amount of resources:
Output of XOutput of Y
Country A18090
Country B200150
In this example, country B has an absolute advantage in both
products. Absolute advantage occurs when a country or region can
create more of a product with the same factor inputs. But Country A
has a comparative advantage in the production of good X. It is
9/10ths as efficient at producing good X but it is only 3/5ths as
efficient at producing good Y.
Comparative advantage exists when a country has lower
opportunity cost, i.e., it gives up less of one product to obtain
more of another product. In our example above, for country A, every
extra unit of good Y produced involves an opportunity cost of 2
unit of good X. For country B, an additional unit of good Y
involves a sacrifice of only 4.3 units of good X.
There are gains to be had from country A specializing in the
supply of good X and country B allocating more of their resources
into the production of good Y.
Another example of comparative advantage
Consider two countries producing two products digital cameras
and vacuum cleaners.
Pre-specialisationDigital CamerasVacuum Cleaners
UK600600
United States24001000
Total30001600
Were the UK to shift more resources into higher output of vacuum
cleaners, the opportunity cost of each cleaner is one digital
television. For the United States the same decision has an
opportunity cost of 2.4 digital cameras. Therefore, the UK has a
comparative advantage in vacuum cleaners.
If the UK chose toreallocate resourcesto digital cameras the
opportunity cost of one extra camera is still one vacuum cleaner.
But for the United States the opportunity cost is only 5/12ths of a
vacuum cleaner. Thus the United States has a comparative advantage
in producing digital cameras.
Digital CamerasVacuum Cleaners
UK0 (-600)1200 (+600)
United States3360 (+960)600 (-400)
Total3000336016001800
The UK specializes totally in producing vacuum cleaners doubling
its output to 1200.
The United States partly specializes in digital cameras
increasing output by 960 having given up 400 units of vacuum
cleaners.
Output of both products has increased - representing a gain in
economic welfare.
For mutually beneficial trade to take place, the two nations
have to agree anacceptable rate of exchangeof one product for
another. There are gains from trade between the two countries. If
the two countries trade at a rate of exchange of 2 digital cameras
for one vacuum cleaner, the post-trade position will be as
follows:
The UK exports 420 vacuum cleaners to the USA and receives 840
digital cameras
The USA exports 840 digital cameras and imports 420 vacuum
cleaners
Digital CamerasVacuum Cleaners
UK840780
United States25201020
Total33601800
Compared with the pre-specialisation output levels, consumers in
both countries now have an increased supply of both goods to choose
from.
We have seen in this chapter how specialisation and trade based
on the idea of comparative advantage can lead to an improvement in
welfare.
supply
Definition of Supply
Supply is defined as the quantity of a product that a producer
iswilling and able to supplyonto the marketat a given price in a
given time period.
Note: Throughout this study companion, the terms firm, business,
producer and seller have the same meaning.The basiclaw of supplyis
that as the price of a commodity rises, so producers expand their
supply onto the market. A supply curve shows a relationship between
price and quantity a firm is willing and able to sell.
A supply curve is drawn assuming ceteris paribus - ie that all
factors influencing supply are being held constant except price. If
the price of the good varies, we move along a supply curve. In the
diagram above, as the price rises from P1 to P2 there is
anexpansion of supply. If the market price falls from P1 to P3
there would be acontraction of supplyin the market. Businesses are
responding toprice signalswhen making their output decisions.
Explaining the Law of Supply
There are three main reasons why supply curves for most products
are drawn as sloping upwards from left to right giving apositive
relationship between the market price and quantity supplied:
1. The profit motive:When the market price rises (for example
after an increase in consumer demand), it becomes more profitable
for businesses to increase their output. Higher prices send signals
to firms that they can increase their profits by satisfying demand
in the market.
2. Production and costs:When output expands, a firms production
costs rise, therefore a higher price is needed to justify the extra
output and cover these extra costs of production.
3. New entrants coming into the market:Higher prices may create
an incentive for other businesses to enter the market leading to an
increase in supply.
Shifts in the Supply Curve
The supply curve can shift position. If the supply curve shifts
to the right (from S1 to S2) this is an increase in supply; more is
provided for sale at each price. If the supply curve moves inwards
from S1 to S3, there is a decrease in supply meaning that less will
be supplied at each price.
Changes in the costs of production
Lower costs of production mean that a business can supply more
at each price. For example a magazine publishing company might see
a reduction in the cost of its imported paper and inks. A car
manufacturer might benefit from a stronger exchange rate because
the cost of components and new technology bought from overseas
becomes lower. These cost savings can then be passed through
thesupply chainto wholesalers and retailers and may result in lower
market prices for consumers.
Conversely, if the costs of production increase, for example
following a rise in the price of raw materials or a firm having to
pay higher wages to its workers, then businesses cannot supply as
much at the same price and this will cause an inward shift of the
supply curve.
Afall in the exchange ratecauses an increase in the prices of
imported components and raw materials and will (other factors
remaining constant) lead to a decrease in supply in a number of
different markets and industries. For example if the pounds falls
by 10% against the Euro, then it becomes more expensive for British
car manufacturers to import their rubber and glass from Western
European suppliers, and higher prices for paints imported from
Eastern Europe.
Changes in production technology
Production technologies can change quickly and in industries
where technological change is rapid we see increases in supply and
lower prices for the consumer.
Government taxes and subsidies
Changes in climate
For commodities such as coffee, oranges and wheat, the effect
ofclimatic conditionscan exert a great influence on market supply.
Favourable weather will produce a bumper harvest and will increase
supply. Unfavourable weather conditions will lead to a poorer
harvest, lower yields and therefore a decrease in supply.
Changes in climate can therefore have an effect on prices for
agricultural goods such as coffee, tea and cocoa. Because these
commodities are often used as ingredients in the production of
other products, a change in the supply of one can affect the supply
and price of another product. Higher coffee prices for example can
lead to an increase in the price of coffee-flavoured cakes. And
higher banana prices as we see in the article below, will feed
through to increased prices for banana smoothies in shops and
cafes.
Change in the prices of a substitute in production
Asubstitute in productionis a product that could have been
produced using the same resources. Take the example of barley. An
increase in the price of wheat makes wheat growing more financially
attractive. The profit motive may cause farmers to grow more wheat
rather than barley.
The number of producers in the market and their objectives
Thenumber of sellers (businesses) in an industryaffects market
supply. When new businesses enter a market, supply increases
causing downward pressure on price.
Competitive Supply
Goods and services in competitive supply are alternative
products that a business could make with its factor resources of
land, labour and capital. For example a farmer can plant potatoes
or maize.
equilibrium price
Equilibriummeans astate of equality or balancebetweenmarket
demand and supply
Without a shift in demand and/or supply there will be no change
in price. In the diagram above, the quantity demanded and supplied
at price P1 are equal. At price P3, supply exceeds demand and at
P2, demand exceeds supply.
Prices where demand and supply are out of balance are termed
points of disequilibrium.
Changes in the conditions of demand or supply will cause changes
in the equilibrium price and quantity in the market.
Demand and supply schedules can be represented in a table. The
weekly demand and supply schedules for T-shirts (in thousands) in a
city are shown in the next table:
Price per unit ()87654321
Demand (000s)68101214161820
Supply (000s)1816141210864
New Demand (000s)1012141618202224
New Supply (000s)2624222018161412
Theequilibrium priceis 5 where demand and supply are equal at
12,000 units
If the current market price was 3 there would beexcess demandfor
8,000 units
If the current market price was 8 there would beexcess supplyof
12,000 units
A rise in income causes demand to rise by 4,000 at each price.
The next row of the table shows the higher level of demand.
Assuming that the supply schedule remains unchanged, the new
equilibrium price is 6 per tee shirt with an equilibrium quantity
of 14,000 units
The entry of new producers into the market causes a rise in
supply of 8,000 T-shirts at each price. The new equilibrium price
becomes 4 with 18,000 units bought and sold
Diagrams to show Changes in Market Demand and Equilibrium
Price
The outward shift in the demand curve causes an expansion along
the supply curve and a rise in theequilibriumprice and quantity.
Firms in the market will sell more at a higher price and therefore
receive more total revenue
The reverse effects will occur when there is an inward shift of
demand
A shift in the demand curve does not cause a shift in the supply
curve!
Demand and supply factors are usually assumed to be independent
of each other although some economists claim this assumption is no
longer valid!
Equilibrium price represents a trade-off for buyer and seller
higher prices are good for the producer (higher revenues and
profits) but they make the product more expensive for the buyer
Changes in Market Supply and Equilibrium Price
Important note for the exams:
A shift in the supply curve does not cause a shift in the demand
curve. Instead we move along (up or down) the demand curve to the
new equilibrium position.
To really understand this topic it is essential for you to
understand the difference between shifts and movements along demand
and supply curves
Theequilibriumprice and quantity in a market will change when
there shifts in both market supply and demand. Two examples of this
are shown in the next diagram:
In the left-hand diagram above, we seean inward shift of
supplytogether witha fall in demand. Both factors lead to a fall in
quantity traded, but the rise in costs forces up the market
price.
The second example on the right showsa rise in demandfrom D1 to
D3 but a much biggerincrease in supplyfrom S1 to S2. The net result
is a fall in equilibrium price (from P1 to P3) and an increase in
the equilibrium quantity traded in the market from Q1 to Q3.
Moving from one market equilibrium to another
Changes inequilibriumprices and quantitiesdo not happen
instantaneously! The shifts in supply and demand outlined in the
diagrams before are reflective of changes in conditions in the
market.
So an outward shift of demand (depending upon supply conditions)
leads to a short term rise in price and a fall in available
stocks.
The higher price is an incentive for suppliers to raise their
output (termed as an expansion of supply) causing a movement up the
short term supply curve towards the new equilibrium point.
Diagrams are a simplification of reality!
We tend to use supply and demand diagrams to illustrate
movements in market prices and quantities this is known
ascomparative static analysis
The reality in most markets and industries is more complex. For
a start, many businesses have imperfect knowledge about their
demand curves they do not know precisely how consumer demand reacts
to changes in price or the true level of demand at each and every
price
Likewise, constructing accurate supply curves requires detailed
information on production costs and these may not be readily
available.
Regulated prices
Not all prices are set by the free-market forces of supply and
demand. In Britain, a number of prices are affected byindustry
regulators good examples are rail fares, the cost of postage stamps
and water bills.
In the rail market, some of the fares are unregulated allowing
train operating companies to set their own prices. But around half
of the fares charged for UK rail travellers are determined by the
rail regulator
You can see from the chart below that average rail fares in the
UK have grown faster than the overall consumer price index. The
result is that the real cost or price of travel has increased over
recent years.
Here is a summary when there is a unique change in one of the
conditions of market demand or supply
ShiftEquilibrium PriceEquilibrium Quantity
Demand increasesHigherHigher
Demand decreasesLowerLower
Supply increasesLowerHigher
Supply decreasesHigherLower
The possible outcomes for price and quantity are less certain
when there is more than one change in demand and supply
conditions
(+) signifies increase in demand / supply
signifies no change in conditions of demand / supply
(-) signifies a fall in demand / supply
The outcome for market price is often uncertain because it
depends on the size of the relative changes in supply and demand in
a given time period.
For example:
A 20% rise in demand and a 8% rise in supply will cause prices
to rise
A 10% rise in demand and a 30% rise in supply will cause prices
to fall
A 25% rise in demand and a 25% rise in supply will cause prices
to remain constant
AS INIT 1 : MARKETS
Prepared by : A.LavanyaPage 27